Economics of Innovation Innovation is the introduction of new products and processes Innovation is generally considered to be an important source of economic growth (the rate of change in GDP) and of labor productivity improvements (increases in GDP per capita) Improvements in productivity are generally considered the main source of welfare improvements over time; real output per person rises As a result, public policies that affect innovation receive a lot of attention from economists Business strategists also emphasize the importance of innovation

Key Factors Affecting Innovation The amount of innovation in an industry depends on three key factors 1.Technological opportunities: it must be technically possible to improve the products or processes 2.Demand: there must be a market for the new product (product innovations) or a desire for lower prices (process innovations) 3.Appropriability Conditions: Innovation improves social welfare. The more of this social return the innovator can appropriate, the higher the investment in innovation

Public Policy Public Policy can affect all of the three conditions 1. Governments support basic research that in the long run improves technological opportunities Firms often do not have the incentive to undertake basic research because it is not appropriable Universities, government labs, think tanks, and other non-profits can pursue basic research Sometimes, firms in an industry join together to form an independent agency to conduct basic research (Sematech, for example)

Government Demand 2. Governments can create demand for new products and processes In 1992 the federal government paid for 43% of the $151 billion spent on R&D in the United States. Private industry paid for 54% Evidence suggests that federal R&D does not crowd out private R&D, and some government sponsored innovations have broad social benefits Consider military R&D or the space program. In 1987, the U.S. government spent 68.8% of its R&D on defense The Internet was originally a Department of Defense project designed to ensure communications during times of war NASA keeps a database of all of the “spillovers” of NASA innovations into society

Appropriability Conditions 3. Governments improve appropriability conditions by implementing legal intellectual property protection Intellectual property protection is designed to create property rights on ideas and knowledge A patent grants a monopoly on using or selling a new product or process for a 20 year period after the date of filing the application A copyright applies to works of authorship, such as books and musical compositions Trademarks are words, symbols, or other marks used to distinguish a good or service provided by one firm from those provided by other firms

Appropriability Most innovation policy analysis focuses on appropriability conditions Appropriability is critical because if none of the social returns of the innovation are appropriable the innovator has no incentive to innovate Innovations have public goods properties: if A shares his idea with B, A may not be able to prevent B from using it without legal protection Government sponsored intellectual property rights may not be necessary in all cases: secrecy and imitation lags may all the innovator to appropriate a substantial amount of the social returns of the innovation